Don’t Fear Derivatives: Letter to the Editor

ALM First Financial Advisors has closely followed the NCUA’s efforts to develop an appropriate rule for credit unions’ use of derivatives as a hedging tool. We support the use of derivatives within the credit union industry as instruments for effectively managing interest rate risk.

Derivatives used for hedging interest rate risk shouldn’t be feared. They are very different from the nonconforming securities that contributed to the failure of several corporate credit unions during the credit crisis. Further, they are easier to understand than some other strategies credit unions deal with today and using them is a normal practice for many financial institutions. As the NCUA highlighted in the ANPR supplemental information, 28% of banks with assets between $250 million and $1 billion, and 57% of banks with assets between $1 billion and $5 billion use derivatives.

Income and firm value are generally created through the use of financial intermediation and balance sheet risk management. Many member assets compete for a place on a credit union’s balance sheet and, constructed properly, may come with unwanted or undesired interest rate risk. Credit union management teams should earn liquidity premiums for being a long-run investor and liquidity provider, originate quality loans and diversify them into a portfolio, and develop a core funding base and service clients. Credit union management teams should not take undue interest rate risk or offer members an abbreviated menu of products because of interest rate concerns.

Credit unions are financial intermediaries for member-owners not rate bettors. Derivatives bridge this gap. Properly used, derivatives can offset interest rate risk that is inherent within the credit union industry today. This is vital because as competition grows, it will allow credit unions to compete effectively.

I encourage credit unions that meet the NCUA’s criteria to educate themselves on the use of derivatives and comment on the recent proposed rule and important modifications necessary to make it a strategy worth considering.